July 10, 2014

A Traditional 401(k) vs. A Roth 401(k)

Credit: Stuart Miles

Another question that came up a few times from readers submitting questions for The Lightning Round was whether I would recommend a Traditional 401(k) or a Roth 401(k). This is actually a very difficult question to answer because it depends on the future tax rates of the individual asking the question. I tried to write an answer (I really did), but I also know that there are times when writing less is worth more. I think this is one of those times. Let’s look at an example…

Suppose Tom has two different 401(k) contribution options. With option one, he can contribute to a Traditional 401(k) plan where pre-tax income is deducted from his paycheck and placed in a tax-deferred account. Tom will have to pay taxes when he takes withdrawals from the account in retirement. With option two, he can contribute to a Roth 401(k) plan where after-tax income is deducted from his paycheck and placed in a retirement account. In this case, Tom will not have to pay any additional taxes when he takes withdrawals in retirement. Suppose Tom’s tax rate is 25% as he contributes and will remain 25% in the future when he takes withdrawals in retirement. Suppose Tom contributed $5,000 per year from his paycheck. Suppose Tom’s investments return a steady 5% per year.

What would happen if Tom went with a Traditional 401(k)?

What would happen if Tom went with a Roth 401(k)?

Are you surprised to see $21,239.15 as the answer to both scenarios? Don’t be! In the Traditional 401(k) scenario, Tom is deferring paying taxes now, so it’s only fair that he pays taxes on his contributions and earnings in the future, right? However, in the Roth 401(k) scenario, Tom is paying the piper (aka the IRS) up front, so why should he be taxed any more on his contributions or earnings years from now?

Great. I’ve mathematically proven to you that it might not make a difference whether you decide to go with a Traditional 401(k) or a Roth 401(k). How does that help you? I hope it helps you focus on the fact that saving for retirement is what really matters, not the Traditional vs. Roth decision.
If you’re expecting to have higher income in retirement than you do now (from things such as Social Security, a pension, or a large inheritance), I’d normally recommend you go with a Roth 401(k). If your income (and your tax rate) will be higher in retirement than it is now, there may be a mathematical difference between choosing a Traditional 401(k) and a Roth 401(k), and a Roth 401(k) will likely be in your favor.

If, like most people, you’re expecting to have a lower income in retirement once your big salary goes away, I’d normally recommend you go with a Traditional 401(k). Save on taxes now while you’re at a higher tax rate and gladly pay taxes on your retirement withdrawals at a lower tax rate when your income is lower. If your tax rate is lower in retirement than it is now, there may be a mathematical difference between choosing a Traditional 401(k) and a Roth 401(k), and a Traditional 401(k) will likely be in your favor.

That leaves one last question. What if tax rates or tax law change between now and when you retire and take withdrawals? Neither of us knows the implications of such a change until it is implemented, but based on our growing federal deficit, I’d guess that if tax rates are going to move, they will be going up. If you’re still on the fence choosing between a Traditional 401(k) and a Roth 401(k), that logic might be a small nod to the Roth 401(k).

In closing,saving is what matters the most – not whether it’s a Traditional 401(k) or a Roth 401(k). If you expect higher taxes in retirement, go with a Roth 401(k). If you expect lower taxes in retirement, go with a Traditional 401(k). If you’re still unclear or nervous about tax rates in the future, hedge your bets - contribute half to a Traditional 401(k) and half to a Roth 401(k). You’ll be half right!

Special Thanks:

I would like to thank Kenny Wuerstlin for the super swank 2MuchCents logo design.

I would like to thank Ryan Halpern for his content advice and editing.

I would like to thank Andrew Davis for his content advice and critiques.

Finally, I would like to thank my wife, Lindley Presley, for her support and content expertise.

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